The euro area economy is rolling along nicely. The 19-country region has registered four years of gradually expanding GDP growth. Inflation has been creeping up to the European Central Bank’s target of ‘below but close to 2%’. The unemployment rate has declined by 2.5 percentage points over the past three years.
The euro has gained ground in the past few months but is 15% below its levels of early 2014. This signals that the policy of Mario Draghi, ECB president, to improve the euro area’s economic health through a more competitively valued currency has paid off.
Against this background, the ECB should be thinking seriously about phasing out its policy of large-scale quantitative easing through bond buying started in March 2015. The ECB council’s next monetary policy meeting on 26 October will see a vigorous debate on whether continued QE is really the right way to fine-tune a further rise in the inflation rate by a few decimal points from the present level of 1.5%.
The danger of an open-ended extension of QE is that the ECB will be tying still more intensely a controversial set of policies to the goal of raising the inflation rate – a parameter over which monetary policy appears to have diminishing influence. Maintained QE is likely to spawn rising counter-productive political and economic effects – problems that will be bequeathed to Draghi’s successor taking over in November 2019.
The German Bundesbank and the Nederlandsche Bank have become under-purchasers of bonds since April. This reflects a shortage of available securities under the ECB’s self-imposed rule preventing countries’ central banks from buying more than 33% of issuance of public sector bonds.
If the ECB were fully confident of the future, it would decide on 26 October to stop the programme by the middle of next year, through a phased reduction of the present €60bn a month QE purchases.
In fact, a range of uncertainties – including the political confrontation over Catalonia as well as the possibility of anti-euro parties emerging strengthened from the Italian elections due next spring – will probably impede the ECB from taking what would otherwise be a sensible decision.
Draghi has borne the brunt of criticism in Germany that the €2tn expansion of the ECB’s balance sheet, by distorting financial markets and inflating asset prices, has increased polarisation between the better- and worse-off sections of society. This, as well as public opposition to large-scale immigration from troubled areas of the Middle East and Africa in 2015, was undoubtedly a big factor behind the 12.6% voting share of the anti-euro, anti-Islamic protest party Alternative for Germany (AfD) in the 24 September German elections.
The price of the flight towards far-right parties and a squeezed majority for Angela Merkel will be two months of wearisome coalition-building and a weakened Berlin government. The German chancellor is embarking on the task of assembling an uncomfortable alliance between her Christian Democrat grouping, the liberal Free Democrats and the Green ecology party.
While all this is going on, the ECB will have little appetite for any significant tightening. Draghi as well as others on the policy-making council remain consumed by the memory of how the euro area, having weathered the 2009 financial crisis and returned to economic growth, raised interest rates prematurely in early 2011, the prelude to a deeper crisis in 2011-12.
Draghi’s problem is that QE has helped engender not only the euro area recovery but also other much less beneficial side-effects that will become more apparent over time.
The Bundestag reconvenes on 24 October, two days before the ECB meeting, with parties that are likely to be highly critical of continued QE. For the first time, the arcane subject of the ECB’s balance sheet seems set to be an issue of high-profile debate in the German parliament, with results that are not likely to make Draghi’s job any easier – nor that of his successor.
David Marsh is Managing Director of OMFIF.